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The biggest business in Robbie Bach’s Entertainment & Devices Group at Microsoft is the Xbox 360 video game business. After many years of losses, the game business is poised to turn a profit, as is the E&D group itself, for the fiscal year ending June 30. Of course, one of the reasons is that the one-time $1.15 billion write-off to repair defective Xbox 360s was included in last year’s fiscal results. In spite of that debacle, Bach is more excited about this business than ever. He actually believes it’s possible for Microsoft, Sony and Nintendo to succeed in the games business in spite of the serious competition because of the broadening of the game market. This is the second edited transcript of an interview Bach did with a small group of reporters in San Francisco.

Q: With the Xbox 360, did you have a way to measure the damage to the brand from the billion-dollar write-off and the defective machines?
A: It’s something we have absolutely tracked. The amazing part of that whole situation is that when we look at brand preference, customer satisfaction, willingness to recommend, none of that data has moved through that whole process. The No. 1 complaint I get from people is that it is taking you too long to fix the console.

Q: Doesn’t it surprise you that fans are saying I want my third or I want my fourth replacement console?
A: It speaks to the power of the product offering and service we provide. That’s my point. In the ordinary course of something like this, you would expect it to show up in the customer reaction data. We just haven’t seen that. It speaks to the fact that they love their games and Xbox Live. Does it frustrate them? Yes. On the other hand, they know we’re taking care of them. People have a certain amount of respect for that. If it had happened on a product that had less baseline customer satisfaction, it would have had a bigger impact. We really haven’t seen that.

Q: Have you had a rebellion on the gamer sites?
A: Not really. Certainly, people will go up there and talk about things. They have this problem or that problem. There is conversation about it. But then you look at the data. People continue to buy. Throughout the whole thing, we didn’t see a drop off in the purchase rate or the attach rate for games. People compartmentalize. They see we had something wrong. We’re dealing with it. But they still love the product and keep using it. That’s the best analysis I have based on the data.

Q: If you go back in hindsight to November of 2005, and your yield was not so good, you could have predicted a big return rate because the yield was so lousy. Did you ask yourself whether you should delay the launch? Wait for the yield to get up? Or just keep going?
A: This is the hard part. The technical nature of the challenge wasn’t related to yield. It wasn’t related to things we were seeing in testing or some judgment call we had to make about whether the product was ready. We were confident the product was ready. We did a lot of testing. The problem that shows up with the three red lights on the console is a complex interaction with some very complex parts. It’s easy for me to go back and say, if I knew what would transpire over the next two years, would I go back and do something different, I think that’s an obvious answer. But the fact is, based on the data we had at the time and all the hard work we put into it, there was no way to see what actually happened. As you know, it didn’t start to show up in the data from our customers for almost a year. This wasn’t like we had a yield problem and three weeks later people were having problems with their consoles. It’s one of those things that nobody is proud of. On the other hand, we are in a complex technology space. You learn from it. You do the right things to make sure it doesn’t happen again. The best thing you can do is tell your customers you want them to keep enjoying the product and here is what we will do on replacing it for free.

Q: Did it turn out to be the right thing to do in terms of console war strategy to go ahead and beat the other guys to market?
A: If you take the question of whether it was the right thing to try to be first, the answer to that is definitely yes. It has given us a leg up in a number of places that are super important. It has given us a leg up with game developers. It has given us a leg up from an economics perspective. It helped us expand Xbox Live quickly. At a strategy level, if you asked if we wanted to be first again, I would say yes. The truth is when we set that date, we didn’t do it to be first. We thought Sony would ship at that point. But they slipped a year.

Q: What is your expectation for the timing of the next console introduction?
A: The last cycle for the original Xbox was a little shorter than typical (at four years). We started way late. Sony launched in Japan in 1999. We launched in the U.S. in 2001. They are still selling PlayStation 2s. You see cycles are lengthening and the ability to have overlapping consoles in the market is growing. For a long time, after Sony shipped PS 3, PS 2 was outselling it. It helps when you have a portfolio business.

Q: Do you want to be first with the next one, too?
A: Too early to tell. Our view is we will be selling Xbox 360 for a long time. We are always working on new technologies. We have people working on those. People ask me how many people I have working on the next generation. On the one hand, it’s everybody. On the other, it’s nobody. People are continuously working on new technology.

Q: What’s the planning cycle?
A: We start thinking about the next generation before we shipped the Xbox 360. It doesn’t start with a date. It starts way upstream with silicon development. From that comes a series of data points. You start making early technology choices. It’s an evolving thing. Stuff doesn’t become concrete until you get inside a window of when you have to ship, more than 18 months or so out.

Q: What is victory for you?
A: In the short term, being profitable is a victory. It’s an important milestone. I want to have a strong business. I do think about the P&L. There has to be a scale to the business. We are achieving that scale today with Xbox. There is a part of victory that is about connected entertainment and how far we have advanced that vision. That doesn’t show up in market share. It shows up in scenarios and how people use the product. There is no concrete market share or profit number. But certainly, having the economics and ecosystem be healthy are measurements of success. The video game business has now gotten big enough, so there will be multiple victors. It’s not as much a winner take all market as it was ten years ago. That speaks to the growth of the market, the diversity of what gamers want, and the ability to differentiate ourselves.

Q: Hitting profits was important here. Do you have a target for profitability over the life of the cycle? What is looking better and what is looking worse about the business model for the Xbox 360?
A: There isn’t a specific dollar number. Partly because we don’t know where the cycle will end this time. Being profitable in the first few years is certainly a milestone target for us. Another is being profitable for the rest of the cycle. Xbox Live has been financially more successful for us. Having written off a billion dollars in hardware costs, that part of the model is worse than we expected.

Q: That didn’t ruin the model?
A: It doesn’t. It doesn’t make it good. Would I like the billion dollars back? Of course the answer is yes. But there is still plenty of economics in the business for us to be successful.

Q: DFC Intelligence predicted that Sony would come in second place in unit sales of consoles in this generation.
A: I’d ask again the definition of victory. Unit sales? Profits? Online activity? Community? There are a lot of different measures. All three of us can be successful. Having 40 percent market share to somebody else’s 30 percent market share is less important than it might have been five years ago.

Q: Do you think Sony did a good job digging out of their hole?
A: Ask them. They have to prove they can get to scale. They are behind on console sales.

Q: Howard Stringer said they aren’t on life support anymore.
A: If not being on life support is the metric for success, then I guess they’re successful. This is going to go on for some time. You look at some metrics and see how things have changed. Xbox Live has done good numbers. Nintendo has done great things with the controller. The Grand Theft Auto franchise is super-successful on Xbox 360. That’s a sign of how far we have come. Four or five years ago, most people would have said three console makers could not be successful. That’s the likely outcome now.

Q: One metric was succeeding in Japan. What’s the situation there?
A: There are things we have to work on in Japan. Mathematically, our share is up a lot in Japan but it’s still small. We are still in single-digit share. Much better than it was. We made progress but there is more work to do. But we have made dramatic progress with Japanese game developers. The numbers of exclusives on PS 2 were plentiful, but you don’t see that anymore. The Japanese publishers discovered that their market was in decline and they had to look overseas for more business. That meant they had to make games for the 360. Good for them. Capcom, Namco, Sega, and Square Enix have done a lot on the 360. Sony owns 19 percent of Square Enix.

Q: What’s the key to market share in Japan?
A: It’s about content. Getting the publishers engaged on our platform is key. Part of it is brand relevance. That takes time to build. It’s no surprise we are more successful in the U.S. market. Sony and Nintendo are more successful in Japan. We’re very persistent. When I was in the Office business, Ishitaro was the No. 1 word processor in Japan. Now the No. 1 word processor in Japan is Microsoft Word. That took seven years. It was a slow, hard slog. Some of it was product related, some brand and cultural relevance.

Q: How has the Xbox 360 Core (arcade model, with no hard drive) sold? Does it make sense to keep it going?
A: We don’t break it out. The Pro SKU, the main system with the hard drive, is the most successful today. We have had success with multiple SKUs. It’s an important way to give different customers a different experience, reach different price points. It’s odd to think one product satisfies everybody. I can’t think of a consumer electronics space where that’s true. There are some who want a big hard drive and store a lot of video. They want the Elite SKU. Others that are price-sensitive — parts of Europe want the Arcade SKU.

Q: How many people are using it to download videos or TV shows or movies?
A: A lot of people use it to watch those things. They watch it in high-definition. That’s a common usage. When you want to download a TV show or movie, we have both a standard definition and a high-def version. Though people pay more for high-def, and even though it takes longer to download, people still prefer it.

Q: How big could this business be?
A: It’s a capability, not a business in itself. It’s a part of Xbox Live. I don’t think of it as a stand-alone business. You don’t buy the box to do the download. The challenge for people doing their own boxes is that someone has to pay $100 to $200 just to get a controller to download movies. And that’s one more box in your living room. Tivo as a dedicated box wasn’t successful. Same as Slingbox. Even Apple TV hasn’t had a lot of success.

Q: But everyone wants to get into the living room?
A: To get there, the consumers have to want you there. Our advantage is that the consumers want us there for the Xbox 360 games. They can also use it for downloading. The business is Xbox Live, not a video download service.

Q: I thought you would be more aggressive about adding hard drives to the consoles.
A: Our Xbox 360 Elite drive isn’t big enough for you? It’s 120 gigabytes.

Q: Yeah, but that’s not much for HD downloading.
A: Fair enough. You have to balance cost and functionality. At some point, the costs of the boxes will come down and you weigh whether to add features or bring down the price so that more people can afford it.

Q: I thought in this generation we might see more periodic hardware updates. Why haven’t we?
A: I guess that’s true. But it’s still early in the generation to conclude that. Nintendo would say they added a new controller. We would say we updated the Xbox Live capability. Are they earth-shattering changes? Maybe not.

Q: What goes into deciding whether to add a Wii-like controller now or to wait?
A: You have to decide if that is the right thing to do, if it’s a scenario that is valuable to the audience you are trying to reach. And what is the right model. There is no magic sauce there. It’s a little trickier to add midway through the cycle because you have to have game developers on board and the right content available.

Q: So the Wii is aiming for a different buying segment and their controller might appeal to a different buying segment and not yours?
A: In general, we joke about the Wii 360 household. It’s not uncommon for people to buy both. I don’t know the exact number, but anecdotally it’s higher than you think. On the Wii, you have a lot of Nintendo content. You might want to do something else besides Mario and play Halo 3 or Grand Theft Auto IV. The devices are so different. That’s less likely to happen between the PS 3 and Xbox 360. The base fundamentals are less different.

Q: How do you size the number of internal game developers inside Microsoft? Sony has been shedding a lot of people. You lost a lot of studios.
A: They went on an acquisition spree for a while. Then they decided they over-turned the dial. We bought Lionhead more than a year ago. Those things go in waves. With Bizarre, it wasn’t ours to keep. Someone decided to buy them. Prices got too high for the developer acquisitions. Economics plays a role. If you look at the transactions of the last 12 months, those multiples didn’t make sense to us. We sat on the sidelines a little bit. Then you have a transaction like Activision-Blizzard-Vivendi. I’m not even sure I can calculate the multiple on that. That’s a very big transaction and an exception.

Q: How do you make sure gaming and social networks complement each other?
A: I don’t know if we think about that in a concrete way. Our job is to provide entertainment experiences in a social setting. I don’t think of them as competition in any way. People get into different modes.

Q: What about touch screen or multitouch screen technology with Xbox?
A: New input is always something we look at in general. The Microsoft Surface technology we are pioneering has game elements to it. There is one crazy experience on Surface where you take a full-motion video, divide it up onto blocks, put pieces of video on both sides of the block, and then ask three people to put the puzzle back together again. It’s a pure free-for-all.

Also check out Part 1 of the Robbie Bach interview, posted yesterday, focusing on Microsoft’s Zune media player.